Price and Underlying Markets

In this lesson:
  • The linear correlation between the call spread price and the underlying market price 
  • The built-in risk/reward structure of the floor and ceiling
  • The edge: the reason the call spread price is higher than the underlying indicative price

Here’s a simple way to think about Nadex call spreads. Instead of trying to trade the entire bottom to top range of a trend, you take one segment of that trend and focus on that. Within that range, your Nadex call spread gains and loses value in correlation with the underlying market's gains and losses. But at the top and bottom of the range, the price stops at a maximum or minimum and doesn't move further. 

A Nadex call spread confines the price action within the floor to ceiling range. When the underlying price goes outside that range, the call spread price will stop moving and rest at the floor or ceiling. If the market comes back into that range, the spread will move with it again.

This gives you a way to trade up or down movement within a price range, without the need for stops. You get movement similar to what you get trading forex, stocks, or futures, but with a limit to how much you can lose and a limit to how much you can gain, giving you a natural profit target.

The floor and ceiling

Call Spreads offer you limited risk by having a minimum value they can’t go below. This means that if the underlying market price moves below that value, the floor price, the call spread’s value won’t drop further. The call spread’s correlation with the market simply disengages and the call spread value stops moving.

It also means that the call spread’s value can only go as high as the ceiling. If you are a buyer and the market goes up, your call spread automatically gives you a profit target, because it won’t be able to increase in value beyond that point. Most traders find this makes planning a trade and sticking to that trading plan easier.

But if the market is continuing to go up, you may want to continue to trade that movement. Because of the short-term nature of Nadex call spreads, you can easily buy another call spread at a higher price and do it again.

Why is the call spread price higher than the underlying market price?

In exchange for the limited risk advantage you get with the call spread, your call spread price is adjusted to include the value of the protection. The call spread price also reflects the profit potential of the call spread, the amount it can continue to go up or down to bring more profits your way.

If the futures price is inside the call spread’s range, then the call spread will have some amount of what’s called “intrinsic value.” Intrinsic value is also factored into the initial cost. You’ll pay more for a call spread that has a higher probability of expiring with a profit.

Because you are paying not just for the futures price, but also the combination of limited risk with profit potential that the call spread gives you, you enter at a small price disadvantage. You give up an edge in exchange for the protection and profit potential you get at such a low cost. 

As a result, the market will have to move a small distance in your direction before you’ll break even and start to profit. This is what makes call spread trading a manageable but challenging way to trade.

Close correlation with the underlying market

When the underlying market whether it’s the Aussie Dollar/Japanese Yen exchange rate, crude oil futures, or the Nasdaq) moves one tick, the call spread price moves one tick as well.

In other words, within the call spread’s range, the price moves the same way the underlying market moves. You won’t see the sudden volatility you might see with options. Neither will you see the price failing to move when the market is ticking up or down slowly. It’s a close correlation until you approach the floor or ceiling. This makes Nadex call spreads a less expensive way to trade the underlying markets from which they are derived.

 

At this point you should understand:
  • How the call spread price moves in close linear correlation with the underlying within the range
  • What the floor and ceiling of a call spread are and how they limit risk and give you a profit target
  • How the call spread is priced relative to the price of the underlying indicative market

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